When Second Best is the Best Choice.

This post is from Danilo Pelletiere, Research Director and Chief Economist, NLIHC.

This week, Financial Timesreviews a book on Fannie Mae and Freddie Mac, the housing government sponsored entities, titled Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance. According to the review, the book makes the case that “sentimentality and social conscience” were as much the undoing of the U.S. housing market as motivations like greed.

Maybe that conclusion can be the subject of a future posting, but along the way Christopher Caldwell of Financial Times makes the statement “Big tax breaks – from deductions for mortgage interest to exemptions from capital gains – subsidise homeowning over apartment-dwelling.” The mortgage interest deduction allows homeowners to deduct the interest they pay on mortgages for their first (and second) homes up to $1 million, and a home equity loan up to $100,000. Considering the number of mortgages in this country it sounds like it could be a big number, and it is: the Office of Management and Budget estimates a cost to the federal treasury of $88.7 billion dollars this year alone.

In a letter-to-editor response (subscription required) to the FT article, Professor Richard Gordon of Case Western Reserve University delves into the technical details of the mortgage interest deduction. He argues that the ideal tax policy would be to retain the mortgage interest deduction while also taxing the value homeowners receive from living in their homes. With his tongue firmly in his cheek he calls the current system in the United States where homeowners receive all benefit and no tax “the promised land.” Yet being overly formal about the matter, Prof. Gordon also concludes in his letter that the mortgage interest deduction “has nothing to do with tax breaks.”

This is quite the overstatement and is likely to lead to some confusion. So a little explanation seems in order. Professor Gordon’s correct that in the idealized world of tax professors, the value of homeowners’ housing consumption would be taxed and their costs, including mortgage interest, would be deducted from what they owe. Given the general and historical complexities of introducing a tax on owners’ housing consumption in the U.S., however, it is widely recognized that the tax professors’ ideal is impractical. Thus the treatment of mortgage interest in the U.S. tax system has everything to do with providing a mortgage subsidy and is rightly called a tax break.

This point is not academic. The money that goes to the deduction is twice what the federal government spends on low income housing assistance.

At the same time, in the U.S. tax system, only higher income households are able to receive the full subsidy. As President George W. Bush and President Obama’s tax and fiscal commissions, the non-partisan Congressional Budget Office, and myriad others have concluded, the current policy does little to boost homeownership and reforms such as moving to a simple and modest tax credit receivable by all mortgage holders would make housing policy more efficient and equitable and also less costly to tax payers.

For economists in the policy world, eliminating the deduction is what is known as a “second best” solution. In other words, it is the best solution given that the ideal is unrealizable. And in the process of achieving this second best we could greatly increase housing assistance to low and moderate income Americans and eliminate homelessness. This is something that our members would describe as the promised land.

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Comments

The mortgage interest and property tax deductions are commonly known as the “middle-class tax breaks.” Mr. Pelletiere is correct to note that they subsidize the affluent more than the middle class. First, deductions produce more tax savings per dollar deducted for affluent persons in higher tax brackets. Second, the affluent buy larger homes, and therefore have much more mortgage interest and property tax payment to deduct. Third, the mortgage interest and property tax deductions are available only to those who itemize their deductions. Affluent households are most likely to itemize deductions whereas the middle class typically take the standard deduction.
Kudos to Mr. Pelletiere for exposing the myth of the mortgage interest and property tax deductions. Subsidizing homeownership for the most affluent is not a wise or affordable course of action.